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It’s no time to be a hero

03/09/2010

Martin Conlon

Head of Australian Equities

A global environment characterised by lack of leadership and lack of new ideas is causing investors much consternation. The continuing strong performance of gold and the reluctance of investors to embrace any risk are outcomes of this leadership vacuum, as both trust and confidence are in short supply. The US in particular, continues to expect monetary policy in isolation to provide the impetus for a recovery and appears intellectually bankrupt when it comes to initiatives for genuine reform. When investors are hanging on the words of Ben Bernanke and his promises to pursue the same policies that created the problems with increasing vehemence, it is unsurprising that more investors are worried about wealth decimation than the rosy days ahead. The regard with which China is currently held when it comes to economic management is perhaps more of an indictment on the parlous state of most democracies than an endorsement of communism.

Commentators broadly characterised the earnings season as ‘mixed’. For those unfamiliar with stockbroking commentary, I will translate: ‘Current year earnings forecasts came in broadly in line with expectations, as they were provided to us by the company last week. On the matter of forward looking estimates, we began reporting season with traditionally over optimistic earnings forecasts which had no basis in either historical fact or economic reality. Revelations of actual performance and a realistic outlook required almost universal downward revision of expectations’. This may be overly cynical, however, it does reflect our continued dismay at the propensity of investors to ignore the reality of the economic environment. Australia has seen almost no ill effects of the global financial crisis and continues to attract in foreign capital, as high relative interest rates, commodity exposure and economic strength override concerns of an overheated property market. With almost no unemployment, limited savings and a housing market that hasn’t declined, there is no downturn from which to recover. Earnings are, in most cases not artificially depressed, and in many, primarily in commodities, are artificially buoyant. This does not mean stocks are overpriced, however, in our view it does mean that investing large amounts of capital based on unrealistic growth expectations may prove unwise.

Signs that corporate confidence was returning, or that cash was burning a hole in their pocket, came in the form of BHP Billiton’s (-7.7%) bid of almost $US40bn for Potash Corporation. Although the strategic rationale for the move might be sound, investors did baulk at the apparently high price for a business that has only in recent years begun to deliver solid performance. Agrium also launched a cash offer for AWB (+46.0%) at $1.50 per share.

Across the spectrum of results, areas of strength included staples such as Woolworths (+7.6%), Coca-Cola Amatil (+5.8%) and Wesfarmers (+5.1%), while the negative side of the ledger included Telstra (-10.3%) and James Hardie (-18.1%).

Outlook

Proclaiming certainty in an environment as unfamiliar and unpredictable as the present is farcical. Indebted countries such as the US and many European nations with problems rooted in excessive consumption are prescribing additional consumption as a cure, whilst peers in Asia with growth based on excessive investment are seeking to invest their way forward. That tensions on issues such as trade and exchange rates should be heightening as this occurs is about as surprising as Alan Greenspan claiming he did nothing wrong. There remains almost no acknowledgement of the possibility that both models may have flaws and that a more sustainable balance between investment and consumption within economies may be desirable for all. It is the fact that economies have let internal imbalances become so pervasive that makes rebalancing so difficult. An economy totally reliant on consumption cannot be spurred suddenly by investment and vice versa. Problems such as population aging and income disparity which are looming but remain ignored only further complicate the investment environment.

The response to the above environment of uncertainty and impasse by most investors is the same as the advice given to Danny Ocean by Terry Benedict in Ocean’s Eleven. “Run and hide”. Despite central bankers trying to flood the world with money, the money isn’t flowing into the real economy. The flood of money does however, tend to polarise the possible outcomes. If it starts to flow, the problem will become one of withdrawal (and controlling inflation). The return of confidence in this scenario is also likely to see sharp rises in equity markets, as it will only take a small ripple in the sea of money to build a large wave. If, on the other hand, overcapacity, exhausted consumers and unbalanced wealth distribution means the flood of money cannot find a productive home, a deflationary scenario becomes a more probable outcome. The problem with these scenarios is that they dictate investment strategies which are polar opposites. We continue to believe that now is not the time to seek hero status through attaching unjustified probability to either scenario. We would suggest that sensible risk mitigation in the current environment should dictate as much diversity as possible, together with a cautious approach to financial leverage. Greed is not always good.

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Investment strategy of recent years has been somewhat monotonous. Martin Conlon, Head of Australian Equities, discusses one the most frequent asked questions we face is: What is the catalyst for these trends to change?

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